Chapter two The Theory of Production and Cost

Introduction

This chapter has two major sections. The first part will introduce you to the basic concepts of
production and production function, classification of inputs, essential features of short run
production functions and the stages of short run production. The second part mainly deals with
the difference between economic cost and accounting cost, the characteristics of short run cost
functions, and the relationship between short run production functions and short run cost
functions.

4.1 Theory of production in the short run

4.1.1 Definition of production

Raw materials yield less satisfaction to the consumer by themselves. In order to get better
utility from raw materials, they must be transformed into outputs. However, transforming raw
materials into outputs requires inputs such as land, labour, capital and entrepreneurial ability.
Production is the process of transforming inputs into outputs. It can also be defined as an act of
creating value or utility. The end products of the production process are outputs which could be
tangible (goods) or intangible (services).

4.1.2 Production function

Production function is a technical relationship between inputs and outputs. It shows the
maximum output that can be produced with fixed amount of inputs and the existing technology.
A production function may take the form of an algebraic equation, table or graph.
A general equation for production function can, for instance, be described as:
Q= f(X ,X ,X ,...,X )1
3 n
where, Q is output and X1, X2, X3,…, Xn are different types of
inputs.

Inputs are commonly classified as fixed inputs or variable inputs. Fixed inputs are those inputs
whose quantity cannot readily be changed when market conditions indicate that an immediate
adjustment in output is required. In fact, no input is ever absolutely fixed but may be fixed

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during an immediate requirement. For example, if the demand for Beer rises suddenly in a
week, the brewery factories cannot plant additional machinery overnight and respond to the
increased demand. Buildings, land and machineries are examples of fixed inputs because their
quantity cannot be manipulated easily in a short period of time. Variable inputs are those
inputs whose quantity can be altered almost instantaneously in response to desired changes in
output. That is, their quantities can easily be diminished when the market demand for the
product decreases and vice versa. The best example of variable input is unskilled labour.

Does a short run refer to specific period of time that is applicable to every firm or industry? If
this condition is rather unique to the firm, industry or economic variable being studied, what is
our basis to classify production as a short run?

In economics, short run refers to a period of time in which the quantity of at least one input is
fixed. In other words, short run is a time period which is not sufficient to change the quantities
of all inputs so that at least one input remains fixed. Here it should be noted that short run
periods of different firms have different durations. Some firms can change the quantity of all
their inputs within a month while it takes more than a year for other types of firms. This sub-
section is confined to production with one variable input and one fixed input.

Consider a firm that uses two inputs: capital (fixed input) and labour (variable input). Given the
assumptions of short run production, the firm can increase output only by increasing the
amount of labour it uses. Hence, its production function can be given by:
Q = f (L)
where, Q is output and L is the quantity of labour.

The production function shows different levels of output that the firm can produce by
efficiently utilizing different units of labour and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus, output can change only when the
amount of labour changes.

4.1.3 Total, average, and marginal product

In production, the contribution of a variable input can be described in terms of total, average
and marginal product.

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Total product (TP): it is the total amount of output that can be produced by efficiently
utilizing specific combinations of the variable input and fixed input. Increasing the variable
input (while some other inputs are fixed) can increase the total product only up to a certain
point. Initially, as we combine more and more units of the variable input with the fixed input,
output continues to increase, but eventually if we employ more and more unit of the variable
input beyond the carrying capacity of the fixed input, output tends to decline. In general, the TP
function in the short-run follows a certain trend: it initially increases at an increasing rate, then
increases at a decreasing rate, reaches a maximum point and eventually falls as the quantity of
the variable input rises. This tells us what shape a total product curve assumes.

Marginal Product (MP): it is the change in output attributed to the addition of one unit of the
variable input to the production process, other inputs being constant. For instance, the change
in total output resulting from employing additional worker (holding other inputs constant) is
the marginal product of labour (MPL). In other words, MPL measures the slope of the total
product curve at a given point.

Q
MPL dTP dL
L

In the short run, the marginal product of the variable input first increases, reaches its maximum
and then decreases to the extent of being negative. That is, as we continue to combine more and
more of the variable input with the fixed input, the marginal product of the variable input
increases initially and then declines.

Average Product (AP): Average product of an input is the level of output that each unit of
input produces, on the average. It tells us the mean contribution of each variable input to the
total product. Mathematically, it is the ratio of total output to the number of the variable input.
The average product of labour (APL), for instance, is given by:
TP
APL 
L

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 Average product of labour first increases, reaches its maximum value and eventually declines.
The AP curve can be measured by the slope of rays originating from the origin to a point on the
TP curve (see figure 4.1). For example, the APL at L2 is the ratio of TP2 to L2. This is identical
to the slope of ray a.

Output
a

TP3

TP2 TP

TP1

Units of labour (variable input)

L1 L2 L3

APL
MPL

APL

Units of labour (variable input)

L1 L2 L3
MPL

Figure 4.1: Total product, average product and marginal product curves

The relationship between MPL and APL can be stated as follows.

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  When APL is increasing, MPL > APL.
 When APL is at its maximum, MPL = APL.
 When APL is decreasing, MPL < APL.

Example: Suppose that the short-run production function of certain cut-flower firm is given
by: Q=4KL-0.6K -0.1L2 2 where Q is quantity of cut-flower produced, L is labour input and
K is fixed capital input (K=5).
a) Determine the average product of labour (APL) function.
b) At what level of labour does the total output of cut-flower reach the maximum?
c) What will be the maximum achievable amount of cut-flower production?
Solution:
Q 4KL-0.6K -0.1L2 2 0.6K 2 15 20L-15-0.1L2
a) AP =L= = 4K - -0.1L= 20- -0.1L=
L L L L L

b) When total product (Q) is maximum, MP will be zero.

MP =L Q = (4KL-0.6K -0.1L22) = 4K -0.2L=0

L L
20
 20-0.2L=0  L= =100
0.2

Hence, total output will be the maximum when 100 workers

are employed.

c) Substituting the optimal values of labor (L=100) and capital (K=5) into the original
production function (Q):
Qmax =4KL-0.6K -0.1L =4*5*100-0.6*5 -0.1*100 =2
2 2
985

4.1.4 The law of variable proportions

The law of variable proportions states that as successive units of a variable input(say, labour)
are added to a fixed input (say, capital or land), beyond some point the extra, or marginal,
product that can be attributed to each additional unit of the variable resource will decline. For
example, if additional workers are hired to work with a constant amount of capital equipment,
output will eventually rise by smaller and smaller amounts as more workers are hired.

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This law assumes that technology is fixed and thus the techniques of production do not change.
Moreover, all units of labour are assumed to be of equal quality. Each successive worker is
presumed to have the same innate ability, education, training, and work experience. Marginal
product ultimately diminishes not because successive workers are less skilled or less energetic
rather it is because more workers are being used relative to the amount of plant and equipment
available. The law starts to operate after the marginal product curve reaches its maximum (this
happens when the number of workers exceeds L1 in figure 4.1). This law is also called the law
of diminishing returns.

4.1.5 Stages of production

We are not in a position to determine the specific number of the variable input (labour) that the
firm should employ because this depends on several other factors than the productivity of
labour. However, it is possible to determine the ranges over which the variable input (labour)
be employed. To this end, economists have defined three stages of short run production.

Stage I: This stage of production covers the range of variable input levels over which the
average product (APL) continues to increase. It goes from the origin to the point where the AP L
is maximum, which is the equality of MP L and APL (up to L2 level of labour employment in
figure 4.1). This stage is not an efficient region of production though the MP of variable input
is positive. The reason is that the variable input (the number of workers) is too small to
efficiently run the fixed input so that the fixed input is under-utilized (not efficiently utilized).

Stage II: It ranges from the point where APL is at its maximum (MPL=APL) to the point where
MPL is zero (from L2 to L3 in figure 4.1). Here, as the labour input increases by one unit, output
still increases but at a decreasing rate. Due to this, the second stage of production is termed as
the stage of diminishing marginal returns. The reason for decreasing average and marginal
products is due to the scarcity of the fixed factor. That is, once the optimum capital-labour
combination is achieved, employment of additional unit of the variable input will cause the
output to increase at a slower rate. As a result, the marginal product diminishes. This stage is
the efficient region of production. Additional inputs are contributing positively to the total
product and MP of successive units of variable input is declining (indicating that the fixed
input is being optimally used). Hence, the efficient region of production is where the marginal
product of the variable input is declining but positive.

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Stage III: In this stage, an increase in the variable input is accompanied by decline in the total
product. Thus, the total product curve slopes downwards, and the marginal product of labour
becomes negative. This stage is also known as the stage of negative marginal returns to the
variable input. The cause of negative marginal returns is the fact that the volume of the variable
inputs is quite excessive relative to the fixed input; the fixed input is over-utilized. Obviously, a
rational firm should not operate in stage III because additional units of variable input are
contributing negatively to the total product (MP of the variable input is negative). In figure 4.1,
this stage is indicated by the employment of labour beyond L3.